MPC: Steady opening for 2nd innings

In its first meeting of 2021-22, the RBI’s Monetary Policy Committee kept unchanged the policy repo rate at 4 per cent and also said that the stance of the monetary policy will remain accommodative. This outcome of the MPC’s three-day long meeting was universally anticipated, particularly in the light of the recent vigorous surge in the Covid-19 caseload in Maharashtra and a few other States. The stock market responded positively while the G-sec prices rose marginally after the policy.

The MPC retained its growth forecast for 2021-22 at 10.5 per cent while the projection for CPI inflation for Q4:2020-21 has been lowered from 5.2 per cent to 5.0 per cent, and that for H1:2021-22 has been raised a bit. Overall, the MPC does not seem to anticipate, at this stage, any serious disruption in demand and supply conditions due to the pandemic’s second wave.

Inflation targeting framework

On a mandatory review at the end of the first five-year period (2016-21) of the inflation targeting framework, the government decided to retain the 4 +/-2 per cent band for the next five years. This has been a very welcome development for the efficacy and credibility of this framework which has served well the cause of macro-financial stability in India. Nevertheless, there was some apprehension beforehand that the mid-point of the target band could be increased to 6 per cent. This was not completely baseless. Even a former RBI governor had warned against any drastic change in the monetary policy framework, which, in his view, could upset the bond market in India. Oddly enough, the fact that has now been articulated by the RBI in the policy in support of the inflation-targeting framework, viz. average CPI inflation during October 2016 to February 2020 was 3.8 per cent vis-à-vis 7.3 per cent during January 2012 to September 2016 has been used by a strong and vocal section in the government to aver that the economy had to pay a disproportionately heavy price by way of foregoing significant GDP growth to lower inflation.

In other words, the government and the RBI/MPC seem to have very different perspectives on the optimal growth-inflation trade-offs for the country’s economy. If the RBI’s in-house research finding that trend inflation has moderated during 2016-2020 to around 4 per cent is anything to go by, then it would be safe to say that the country’s macroeconomic environment is now on an even keel not witnessed in decades on end.

However, the understanding between the government and the RBI in the wake of the retention of the inflation target seems to be a renewed commitment of the latter to support not only the government’s borrowing programme for 2021-22 but also to pursue fiscal-friendly policies, in general.

Notwithstanding all this, it must be acknowledged even by the most ardent critics of the inflation-targeting framework that in its absence, the monetary and liquidity management by the RBI in the face of the unprecedented rise in the fiscal deficit in the wake of the pandemic would have been very difficult and risky indeed.

The RBI’s response to the developments in the G-sec market, especially the gyrations in the 10-year yield in the recent months reveals consternation and some frustration too. For almost a year now, foreign portfolio investors have been selling G-secs and domestic banks are getting increasingly reluctant to purchase long-maturity G-secs on concerns of a ballooning fiscal deficit, higher inflation etc. The rising trend of the yield got accentuated in March on the back of a significant sell-off in the US Treasuries market.

In the meanwhile, the market was correct to conclude that the RBI’s pain threshold for the 10-year yield is 6 per cent and as this number zoomed past 6.2 per cent in the second week of March, one witnessed the market being accused of vigilantism and prowling by the RBI, albeit through the use of colourful imageries and metaphors. But in plain language, this meant a not-so-veiled threat that the RBI would not tolerate G-sec yield in excess of 6 per cent.

There are media reports that the government expects the average borrowing cost in 2021-22 for its long-term papers to be in 5.8-5.9 per cent range. In this policy, the RBI has again vowed to ensure ‘orderly evolution of the yield curve governed by fundamentals’, while adding a somewhat ambiguous narrative that has long been used to explain and defend its interventions in the forex market: the RBI doesn’t target any particular yield level, but aims to eschew volatility in the G-sec market which provides the benchmark for pricing of debt issuance by both the public and private sector entities.

The G-sec yield fell by about 4 basis points after the monetary policy, mainly because of the announcement that RBI will acquire ₹1 lakh crore of G-secs by way of open market purchases in 2021-22, the first such purchase involving ₹25,000 crore being done on April 15.

The tough posture of the RBI vis-à-vis G-sec needs to be analysed and understood well. Is the RBI telling us that the bond market shouldn’t be vigilant about inflation, growth, fiscal deficit etc.? Isn’t the financial market a place for price discovery to ensure the most efficient use of resources? While on this subject, a simple truism needs to be acknowledged: an efficient financial market is no more infallible than the central bank which regulates it. Given this, it is not unthinkable even for the government to submit to market discipline.

The RBI’s anxiety to successfully complete the government’s massive borrowing programme for 2021-22 at ₹12.06 lakh crore at a low average yield is understandable, but it should not happen in a way that seriously attenuates the market’s price discovery mechanism. This aspect assumes significance because, despite the large liquidity surplus, banks are not yet convinced to purchase long-dated G-secs at the prevailing yield levels. A much larger programme for G-sec buying by the RBI than announced in this policy is likely be needed to meet both the volume and price objectives of the government’s borrowing plan for 2021-22.

Among the slew of regulatory measures announced, two merit special mention. One is the decision to set up a committee to review the working of Asset Reconstruction Companies (ARCs). This was long overdue because ARCs in India are underdeveloped in terms of their extant business vis-à-vis the potential in this regard, one of the reasons for which has been archaic regulation. The immediate trigger for the step taken by the RBI is the 2021-22 Budget proposal to establish a ‘bad bank’ in India. One only hopes that the recommendations of the committee are expeditiously given effect to.

The other is the decision to allow non-bank payment system operators to take direct membership in the RTGS/NEFT payment system in a phased manner. This will reduce settlement risk in the financial system and expand the reach of digital financial services to all user segments. But it is not clear, how deep and meaningful their participation in RTGS/NEFT will be in the absence of any liquidity facility from the RBI to facilitate the settlement of their transactions. As the cliché goes, only time will tell.

The writer is a former central banker and consultant to the IMF (Through The Billion Press)

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